1. How to use GuruFocus - Tutorials
  2. What Is in the GuruFocus Premium Membership?
  3. A DIY Guide on How to Invest Using Guru Strategies
Magic Diligence
Magic Diligence
Articles (212)  | Author's Website |

Square Is a Fast-Growing Company in a Great Industry

There are so many wonderful attributes of the payment processing business

October 30, 2018 | About:

Earlier this year, we went through many of our very favorite industries to go hunting for investments in.

One of the industries we highlighted was the payment processing industry.

There are so many wonderful attributes of this business. For one, payment processing is a very stable business, with a very high percentage of recurring revenues. These companies process millions of transactions per day from their customers, taking a small percentage cut of each. While certainly transaction volume would fall in a recession, the fact is that a lot of these transactions are non-discretionary, for items like food, housing, child care, transportation and so forth. Payment processing companies can rely on stable cash flows.

Another great aspect is the fact that there is a global "war on cash" occurring right now. Electronic payments are faster than cash, safer than cash and easier to track and record than cash. Consumers, merchants and governments all prefer electronic payment for the most part -- a real rarity! This sets up an enormous addressable market where there will be 750 billion electronic payments per year by 2020 -- and increasing at double digit rates! There are few markets in the world as enormous that are growing this rapidly.

Finally, payment processors have what we call a "sticky" business. Payment acceptance is one of the very core processes of any business, and once a working system is in place, most merchants are loathe to switch out of it. This creates inertia that allows payment processors to keep their customers, benefiting as they grow their sales.

So, clearly, payment processing is a wonderful business. However, a lot of the major names in this space and are big, over $100 billion dollar companies. While many of these are damn good companies -- and likely successful investments -- the real impressive gains come from finding somewhat smaller companies with similar market potential.

In this vein, this month we'll profile just such a company -- Square (NYSE:SQ). Not only does Square fall into the smaller, higher growth end of the payment processing space, but the stock has also taken a 25% haircut over the past month, making it more enticing than ever. Is it a good buy right now? Let's see...

The flea marketpayment processor

Square started life by providing a rather clever solution for traditionally cash-or-check-only businesses to accept credit card payments.

Square built a simple card reader device that plugs right into the merchant's smartphone or tablet device. Combine this with a matching app (the software side) and, voila!, the merchant instantly had a point-of-sale terminal! Square merrily took about 3% of each transaction, along with some money for the hardware and onboarding fees.

The company has since built out its offering into adjacent categories. Square now offers additional software for inventory management, payroll processing, invoicing, gift card management and order management. It also has a business lending arm (Square Capital), and a restaurant delivery service (Caviar). Additionally, it has tailored its point-of-sale software for specific industry categories, such as restaurants, retail and appointment-based service businesses. Square offers many of these add-on features as cloud-delivered software-as-a-service (SaaS), which customers subscribe to and pay for on a recurring basis.

Perhaps even more important is that Square as been able to sell its payment and software services to ever larger customers. At the end of last year, customers with over $500,000 of gross payment volume accounted for 20% of customers, up from 9% just a few years earlier. This is a big deal, as larger customers tend to be stickier and less likely to go out of business, be acquired or try something else.

In all, transaction fees still account for the vast majority -- about 80% -- of revenues. Subscription fees account for 16% of sales, while the rest (hardware and bitcoin) make up the remaining 4%. It should be noted, though, that subscription fees are the fastest growing. Just three years ago they were only 5% of sales.

Big-time growth

Square is delivering big- time growth. In the most recent quarter, revenues grew 48% year-over-year. Even considering the impact of acquisitions, that represents a pretty impressive step up from 30% growth delivered in 2017.

Management believes it has a very large market to address. In the U.S. alone, Square estimates a potential $26 billion dollar market for small-medium business (SMB) payment processing, $14 billion from Square Capital, $12 billion from its various subscription software offerings, $11 billion from Caviar and $6 billion from e-commerce software, putting the total addressable somewhere near $65 billion. What's more, they also estimate the international opportunity in the same verticals as more than five times that large!

All told, this is a very attractive growth market for a company that will just cross $3 billion in revenues this year. When compared to competitors like PayPal (NASDAQ:PYPL) ($15 billion in revenue) or Visa (NYSE:V) ($20 billion), Square is just getting started. That makes its growth potential all the more enticing for us as investors.

The competition and risks

While payment processing is a great business that mitigates many typical business risks, Square is certainly not without its challenges, both acute and chronic.

Acutely, much of the recent stock price drop was due to the announcement that Chief Financial Officer Sarah Friar is leaving the company at the end of the year to take the CEO spot at Nextdoor. This is a big hit, as Friar is easily the most visible company officer to investors. It is also worth noting that she may be its most important executive, considering CEO Jack Dorsey doubles up as chief executive for Twitter (NYSE:TWTR) as well. Top-level turnover is always reason for pause, and this is no exception.

On a more chronic basis, given that this is a huge potential market, the lineup of competitors is both long and strong. PayPal offers very similar services to Square, with a more robust international footprint, wider vendor acceptance and stronger e-commerce offerings. Large tech companies, notably Apple (NASDAQ:AAPL) and Google (NASDAQ:GOOG), have introduced their own payment processing layer services. Countless other SaaS firms are attacking the business software market for inventory, payroll and order management.

At present, the market is plenty large enough for all of these players without affecting pricing. However, should we start to see competitors resort to price wars to win new business, it would raise concerns. Additionally, should Square's revenue growth trajectory take a massive hit due to competitive deficiencies, it would be another cause for concern.

What's it worth

One big difference between Square and some of the competitors mentioned is that, to date, Square is unprofitable -- although it should flip to profitability late this year or early next year.

That said, the firm is cash flow positive, which is far more important. While cash profitability is still pretty minimal at this point (4.6% on revenues last year and 2.7% in the trailing 12 months), management has reported "adjusted" Ebitda margins of about 15%. These are a decent proxy for targeted cash flow margins. Similar, more mature competitors like PayPal generate free cash flow margins in the low 20% area. It seems reasonable to assume that Square will eventually be able to generate the same kind of profitability.

To get a valuation, let's lay out some assumptions on top of this 20% long-run free cash margin assumption. We see revenue increasing at 45% this year, 30% next year, followed by a gradual decline from the mid-20s. Share dilution has been meaningful, so we model a 9% increase in shares this year, 7% next year and 5% for several years after that. We use a target mature price-earnings ratio of 21, which is fairly conservative for this kind of business. Last, a 12.5% discount rate bakes in the reasonable amount of risk faced from an unprofitable business with a lot of strong competition.

After the math, we get a target price of about $79. That makes the company's $74 current price seem like a decent -- if not screaming -- buy.

Over the long term, Square looks like a solid business that should do very well for shareholders, and today's price seems like a good place to get in for new investors.

Read more here:

Square’s Stock Price Fall Could Increase Its Investment Appeal

US Market Indexes Close Lower Thursday, Dow Ends Consecutive Gains

Square Beats 2nd-Quarter Earnings Estimates

About the author:

Magic Diligence
Old School Value is a stock grader, value screener and valuation tool for busy value investors.

Visit Magic Diligence's Website

Rating: 2.5/5 (2 votes)



Please leave your comment:

Performances of the stocks mentioned by Magic Diligence

User Generated Screeners

pascal.van.garsseHigh FCF-M2
kosalmmuseBest one1
DBrizanall 2019Feb26
kosalmmuseBest one
DBrizanall 2019Feb25
MsDale*52-Week Low
Get WordPress Plugins for easy affiliate links on Stock Tickers and Guru Names | Earn affiliate commissions by embedding GuruFocus Charts
GuruFocus Affiliate Program: Earn up to $400 per referral. ( Learn More)

GF Chat